At the closing of most private M&A transactions, a portion of the consideration is either held back by the buyer or set aside in a third-party escrow to secure the selling company’s covenants, representations and warranties. Based on data from over 500 M&A deals where we have served as the post-closing shareholder representative, 93% of such deals include either an escrow or holdback. In addition, many deals have a second “special escrow” covering specific matters or issues (as described below). Our data (available with accompanying analysis in our Forsite™ M&A Deal Tool) shows that 26% of all deals have at least one additional special escrow:
These special escrows work either separate from or in conjunction with the primary escrow, and cover matters such as (1) adjustment of the purchase price post-closing following determination of all account balances as of the closing date, (2) intellectual property representations, (3) specific existing or threatened litigation or (4) estimated tax issues. The frequency of these special escrows are set forth below:
Special escrows that deserve particular attention are intellectual property escrows and litigation escrows.
Intellectual property escrows are included in M&A transactions to enable longer survival periods for IP representations and warranties. Often the buyer is willing to allow standard representations and warranties made by the seller to expire 12- to-18 months post-closing, at which time escrowed funds are released to the shareholders. However, the buyer may desire a longer survival period for IP representations and warranties. The IP may be fundamental to the buyer’s purchase decision, but problems with the seller’s, and then the buyer’s, right, title and interest in the IP may not manifest themselves for three or more years. Buyer may insist on an extended escrow period to protect the investment in the seller’s company and IP. Rather than extending the term of the primary escrow, the buyer and seller can compromise by allowing the primary escrow to expire and be released early, with a second, longer IP escrow serving to cover IP issues.
A second common special escrow is one established to protect the buyer against a filed or threatened lawsuit known at the time of the closing. Buyer and seller typically negotiate an amount for such an escrow equal to the maximum reasonable loss on the claim (regardless of the merits), with the excess funds released to the shareholders immediately on settlement or resolution of the claim. The buyer benefits from having a dedicated amount in addition to the primary escrow to handle the matter, and the selling shareholders benefit both from immediate release of excess funds on resolution and through the ability to negotiate enhanced control rights over the defense and resolution of the claims.
However, a special escrow covering a filed or threatened claim comes with a significant downside. At closing, the merger agreement typically is provided to the selling shareholders in connection with seeking approval of the transaction. The shareholders also receive a complete description of the financial terms and flows of consideration. Thus, all the shareholders become privy to the existence of the special escrow. We have seen multiple instances where, despite confidentiality obligations, the term and amount of the special escrow has been shared with the claimant (and in some cases, the claimant is also a shareholder). This has emboldened the claimant to seek the maximum recovery, knowing money has been set aside. As a way to deal with this issue, the special escrow amount could be added to the primary escrow, and that “signaling” would not exist.
Please contact us if you would like to discuss this issue or any other post-closing matter in connection with M&A transactions. You can explore further in Fortis Advisors’ Forsite™ M&A Deal Tool our reference tool for the M&A community to empower dealmakers with the data they need to understand “market,” negotiate better deals and follow emerging trends. For additional insights into the data, along with practice tips on M&A transactions, you can read further in our After Closing Series, Fortis Insights and Case Studies.